Can a Lender Put Me in Default for a Technical Breach?
Here is a chilling scenario that happens more than you think. Borrower secures commercial mortgage back securities (CMBS) or other financing for the purchase of an office building or shopping mall. After a major tenant leaves, the cash strapped borrower decides to borrow some short term money to spruce up the property and make it more appealing to new tenants.
After the financing is secured, the borrower receives a default notice and learns the primary loan has been sent to special servicing. The borrower is shocked as it has never missed a payment or even been late. But the special servicer just doesn’t seem to care.
Can a lender call a default if the only “breach” was obtaining additional financing? The answer is “maybe.”
Unfortunately, the loss of the major tenant or the secondary financing often causes lenders to declare the loan in default despite no missed or late payments.
Borrowers understand the consequences of missing a mortgage payment but many don’t know that most loan documents allow an otherwise performing loan to be declared in default and put into special servicing even though the mortgage, taxes and insurance were paid timely. These so-called non-monetary or non-payment defaults are unfortunately common.
Most loan documents allow the noteholder to be placed in default if a payment is missed or more than a few days late. These agreements, however, typically contain a wide variety of other provisions which allow the note to be declared in default.
Common nonmonetary default provisions include:
- Repeated late payments
- Loss of anchor tenants
- Occupancy that falls below a certain percentage threshold
- Unpaid taxes or insurance
- Mechanic’s or materialmen’s liens
- Diminution in value of the collateral (expressed as a percentage loan to value ratio)
- Obtaining secondary financing
We have seen mortgages that allow the mortgage to be placed in default if the lender “feels unsecure”!
This post looks at secondary financing as grounds for default.
Secondary Financing as a Grounds for Default
Courts generally don’t like non-monetary defaults. That said, in the world of commercial transactions, courts still must consider the plain language of the loan documents. Unfortunately, novice buyers frequently don’t pay attention to all the situations and factual scenarios that allow a lender to declare a default.
Lenders believe that having a second or third lien on a property is a sign that a borrower may be getting overextended. The more money borrowed, the less equity the owner has. If the owner has no financial stake in a property, he is more likely to stop paying and just walk away.
Let’s look at a real world situation.
Heron Lakes Office Park Sent to Special Servicing
Heron Lakes, a 313,000 square foot office complex in Houston, was defaulted last December (2018) after the special servicer (Midland Loan Services) learned that the owner had borrowed an additional $11 million on the project. (The first mortgage was for $52 million.) Under the terms of the original loan agreement, the borrower was not allowed to obtain additional financing without permission.
The market for commercial office space in Houston is presently soft. Lenders are concerned about high vacancies and insufficient demand.
When markets are soft, lenders are more worried. One might reasonably think that in soft markets, special servicers would be more willing to work with struggling borrowers or borrowers seeking to improve their property. That isn’t always the case, however.
Given the way special servicers are paid, there is often a financial incentive to keep the borrower in default!
To understand why this is so, let’s look at the role of a special servicer.
In many loans, the originating bank sells the loan to a trust. These are CMBS loans. Banks have people and offices. A trust is nothing more than a pool of loans owned by institutional investors (bondholders). A trust has no employees or offices.
In CMBS loans, a servicer or trustee makes sure the mortgage, taxes and insurance are paid. If there is a problem, however, the loan goes to a special servicer.
Special servicers have a great deal of power. They can modify loan terms and declare defaults. And under the terms of the loan, they can also collect default interest, forbearance fees, counsel fees and several fees you probably haven’t heard of.
Although the special servicer has a duty to protect the trust, the trust has no employees. There is really no one to look over the servicer’s shoulder. The longer the property remains in special servicing, the more the special servicer gets paid. And the more fees that are charged, the more likely that the borrower will lose the property.
As bad as this sounds, it gets worse, Under the pooling and servicing agreement (PSA) that is contained in most CMBS loans, the special servicer has the right to bid on the project. If the property has equity, the special servicer may decide to buy it for its own portfolio.
If you are thinking that this is a massive conflict of interest, you are probably right but the borrower has no standing to raise that issue. Only the trust can raise the issue (and the PSA often allows it).
[If you are feeling bad for not knowing these things, don’t. You aren’t alone. The PSA is often 600 pages or more of fine print. Few borrowers read these agreements.]
This means that projects seriously underwater often get treated better than good borrowers with lots of equity. Why? A borrower seriously underwater has little equity and no cash flow to pay fees.
Technical Default vs. Material Breach
Thus far we have determined that a lender might be allowed to declare a default if a borrower obtains additional financing without permission. But will the courts allow this?
The real question for borrowers becomes whether something as minor as borrowing additional money be grounds for a breach. Courts are usually not happy about lenders and servicers declaring non-monetary defaults. Despite the precise language in the loan documents, courts sometimes say that the law should take into account equitable considerations. In other words, the remedy should be commensurate with the alleged default.
Sahadi v. Continental Illinois Bank & Trust
One of the leading cases on the distinction between technical defaults and material breaches is an appellate court decision from 1983.
GLE, an international shipping company, first borrowed money from Continental Illinois Bank & Trust in 1976. For ease in telling the story, we will refer to Continental as the bank. The initial loan was guaranteed by Fred and Helen Sahadi.
The relationship between the parties subsequently soured. GLE and the bank were threatening to sue one another over purported breaches. In October 2017, the parties agreed to part ways and entered a settlement. Under the agreement, a payment was due on November 15th.
On the 16th, the bank inquired of GLE if the payment had been made. It had not. The bank then declared the loan in default. GLE offered to immediately pay but the bank refused the payment.
GLE was “destroyed” by that action according to the court and filed bankruptcy. That left the Sahadis holding the bag because of their personal guarantee.
The Sahadis claimed that a one day late payment breach wasn’t material and that the bank had always accepted late payments. The trial court disagreed, however, and said the loan documents were unambiguous.
On appeal, a federal appeals court reversed the decision and sided with the Sahadis.
In ruling that the trial judge should have considered whether the breach was material, the court said, “It is black letter law in Illinois and elsewhere that only a “material” breach of a contract provision by one party will justify non-performance by the other party. Moreover, the determination of “materiality” is a complicated question of fact, involving an inquiry into such matters as whether the breach worked to defeat the bargained-for objective of the parties or caused disproportionate prejudice to the non-breaching party, whether custom and usage considers such a breach to be material, and whether the allowance of reciprocal non-performance by the non-breaching party will result in his accrual of an unreasonable or unfair advantage.
So did a one day delay of payment – where the borrower was fully ready and able to make the payment – prejudice the bank? Did the bank routinely accept late payments? The answers to these questions are obvious.
So, what about a borrower getting a second mortgage as in the current Heron Lakes project? The answer isn’t as obvious. Does it matter that the borrower always paid promptly? Does it matter that the borrower increased the borrowing by 20%? Would it matter if it was only 5%? Was the lender harmed by this? Does it matter what the money was used for? Would it matter if the servicer offered secondary financing at 12% interest but the borrower found cheaper financing?
As you can see from the court’s guidance, determining whether a breach was material or merely technical is factually intensive.
We like the ruling because it restores common sense to the attempted actions of aggressive lenders and servicers. Too often we see attempts to declare immaterial technical defaults or steal the project. Imposing a requirement that a default be material is a welcome check on loan documents that are almost always biased in favor of the lender and against the borrower.
I Have Been Wrongly Declared in Default, What Can I Do?
We understand that you worked hard to build a successful business. If your property is worth saving or if you are on the hook for a personal guarantee, call us immediately. We are lawyers that sue special servicers and lenders, this is what we do. And we never represent special servicers or banks.
For more information, visit our CMBS special servicer information page. Have a specific question? Contact attorney Brian Mahany at [hidden email] or by phone at 414-704-6731. All inquiries protected by the attorney – client privilege and kept completely confidential.
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